Adjustment via fiscal policy

The success of economic policy adjustment hinges on the efficiency of fiscal policy.

By giving up autonomous monetary policy, the task of dampening the aggregate effects of asymmetrical shocks is taken over by fiscal policy. Fiscal policy can only respond in a timely and efficient manner if there are no structural rigidities in the

63 Eurostat (2001b).

Table III-12

* Unadjusted for the effect of age differences, sex, education, etc.

Percentage differences

way. Should a negative shock hit the economy when the budget is already suffering from high debt and/or deficit, fiscal policy would not be able to respond immediately and there might even be a worsening in the factors bearing on its ability to adjust.

Fiscal policy works in two ways: the automatic stabilisers and discretionary measures.⁶⁴These channels are not effective unless fiscal policy has the necessary scope of action.

Two of the nominal convergence criteria pertain to the budget, requiring that consolidated government debt and current deficit not exceed 60% and 3% of GDP, respectively. Unlike the relative criteria on inflation, exchange rates and interest rates, these are absolute figures. Within these limits, the Stability and Growth Pact requires that the planned deficit be zero on average over the economic cycle, and that countries with large debt and high future fiscal commitments (e.g. expected pension increases) even plan for a slight surplus. These requirements are designed to ensure that accession countries have the necessary leeway for manoeuvre in fiscal adjustment, both in respect of the automatic stabilisers and active policy instruments.⁶⁵

The automatic stabiliser effect of governmentarises from the fact that receipts and expenditures change in opposing directions over the cycle, i.e. when activity is strong, social spending (such as unemployment benefits, for instance) declines

64 In practice, it is methodologically difficult to measurethe size of the necessary transitory deficit and the cyclical positionof fiscal policy. It is even one of the requirements for EU membership that in addition to fiscal stability member countries should also include a historical and prospective description of their cyclical budgetary positions in the convergence programmes, using a uniform methodology.

These indicators are instrumental in economic policy coordination within the EU. Countries participating in the monetary union draw up stability reports while non-participant union members (members with a derogation) submit convergence reports every year. The reports must be in line with the Broad Economic Policy Guidelines passed by ECOFIN. Accession countries prepare a Pre-Accession Economic Program, which is also aimed at stability and convergence.

65 The experience of the EU countries suggests that the Maastricht deficit criterion leaves sufficient leeway for fiscal policy to adjust to the cyclical movements of the economy. In the past, shocks would have only rarely led to a situation when the 3% limit is exceeded, provided that the countries involved did not have an initial deficit higher than 1 to 2%. Providing that the initial deficit is near zero, only permanent and severe recession would lead to exceeding the 3% criterion. However, the sanctions contain exemptions for such situations, especially if the recession is caused by factors that are not controlled by economic policy. Furthermore, in the past there were no similar restrictions on fiscal policy as those laid down in the Stability and Growth Pact, so, clearly, these requirements are not so strict that they hinder adjustment within EMU.

and tax revenues rise, thereby increasing the government’s receipts. As the two items are entered on opposite sides of the budget, their changing in opposing directions dampens the cyclical upswing. At the time of a downswing, everything happens the other way round, with the automatic stabilisers mitigating the economic slowdown. Not every budget item has equal importance to cyclical stabilisation. The most sensitive items are corporate profit taxes, and the least sensitive are social security contributions, which are, in general, regressive. The sensitivity of personal income taxes and value added taxes lies somewhere in between the previous two.

Comparable calculations for automatic stabilisers (or cyclical components) carried out by the EU member countries have revealed that the automatic stabilisers within monetary union vary widely in size. They are typically in the upper range in small and Northern countries relative to larger and non-Northern countries.⁶⁶According to the EU Commission’s calculations the marginal sensitivity of the budget balance as a proportion of GDP is at 0.5% on average for the EU-15 as a whole, with individual percentages of 0.5 for Germany and Portugal, 0.6 for Denmark, Belgium and Spain, 0.7 for Finland, 0.8 for the Netherlands and 0.9% for Sweden. By contrast the figure for Greece was as low as 0.4. These numbers indicate that based on the EU-15 average, if GDP grows at one percentage point below trend, the budget deficit will increase by 0.5% as a proportion of GDP.

As the highest tax receipts are associated with the evolution of wages and consumer spending in Hungary, fluctuations in the economic cycle will not automatically create significant tax surpluses or losses, as wages and consumption fluctuate less markedly than the cycle. Items on the expenditure side are not significantly sensitive either, with unemployment benefits having a low weight and wages, linked to pensions via Swiss indexation, fluctuating only moderately. As far as tax receipts are concerned, corporate profits and investment are the two areas that could be affected more by the cycle. Due to the low tax burden on these items, however, the current budgetary sensitivity is estimated to be merely 15% in Hungary.

66In the period from 1960 to 1997, the largest negative cyclical component within the EU-15 countries stood at –1.3% on average, and the largest positive figure was 1.7% as a proportion of GDP. In a breakdown by country the corresponding percentages were –1.1 and 1.6 for Greece, –2.1 and 2.8 for Spain, –2.7 and 2.0 for Ireland, –2.4 and 2.4 for Portugal and –5.9 and 5.3% for Finland [see Buti et al. (1998)].

The smoothing effectof the automatic stabilisers also depends on factors such as the openness of the economy and the share of the public sector, in addition to the deficit’s marginal sensitivity and the tax receipts and expenditure structure. In small open countries, the smoothing effect tends to be smaller, due to the imported components of aggregate demand. Accordingly, achieving the same smoothing effect requires higher variability in the deficit. A larger public sector also tends to have a greater smoothing effect. The European Commission estimates the automatic smoothing effect for EU member states to be in the range of 15% to 41%, assuming unit shocks. In other words, if automatic stabilisers are allowed to work, cyclical swings will be 15-41% lower than otherwise.⁶⁷

No comparable calculations have been prepared to describe the fiscal smoothing effect in Hungary. As in terms of the government’s tax and expenditure structure Hungary resembles the class of less cyclically sensitive European countries, and in terms of openness it is like the countries that have a small stabilising effect, the Hungarian fiscal sector will resemble the group where the automatic stabilisers play a less pronounced role (such as mainly the South European countries, with a value below 20%). On the other hand, due to the openness and the ongoing catch-up process, Hungary must be prepared for higher-than-average volatility in the output gap. Consequently, stabilising the economy may require stronger reliance on discretionary moves aimed at boosting investment activity, which tends to be more exposed to cyclical fluctuations.

Smoothing by discretionary moves is allowed as fiscal planners have some leeway in modifying the majority of expenditures. Apart from the relative inertia they have, state-financed or subsidised projects - expenditures typically viewed as provisional items - can react flexibly to cyclical changes. This is because, depending on commitments and the state of completion of various projects, it is equally possible to launch or speed up projects and slow down or postpone new ones. Flexibility to make adjustments is also there during the year as the government controls the allocation of reserves set aside to cover unforeseen expenses (and unrealised receipts), in addition to having the power to decide on the utilisation of chapter and institutional residual funds or the freezing of appropriations. It is also possible for

67 Measures obtained are 15% for Greece, 18% for Portugal and Spain, 31% for Ireland, 30% for the Netherlands and Germany, 41% for Finland. Buti et al.(1998) P. 135 Table 9.4.

Parliament to pass a supplementary budget if there is a danger of a higher-than-planned deficit, or to amend the budget to decide on the allocation of possible excess revenues. The Budget Act contains fewer constraints for institutions that perform government functions outside the government’s legal framework. Specific regulations govern the activity of the State Privatisation and Holding Company (ÁPV Rt.), with the exception of reserve utilisation. As far as other organisations are concerned, the Act sets a ceiling for state-guaranteed borrowing. As some of the capital expenditures at the government’s discretion, such as road construction, are financed by such extra-budgetary organisations, there is a high degree of flexibility during the year.